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Monday, July 28, 2014

Stock Markets Only Go Up?

Stock indexes in Canada have risen so steadily for the past year that the part of my brain that is no good for investing is convinced that everything is different now and stock markets only go up. Let’s let that part of my brain think some more.

Now that my stocks will beat inflation by 25% or so every year, I can throw the 4% rule out the window and go with a 20% rule. My current savings can produce way more than enough income to cover my lifestyle. So, I can declare myself financially independent and ramp up my spending by a factor of four or so.

Believe it or not, many people really talked this way during the tech bubble of the late 1990s: “as long as I can make 15% or 20% a year on my stocks, I can retire soon …”.

That’s a nice daydream, but my more rational side needs to take over. A stock market correction is coming. It may come soon or it may come after markets rise another 50%, but it is coming. The future holds many small corrections and the occasional larger one. I can reasonably hope for lumpy returns that beat inflation on average by a modest margin. As long as I keep my costs low, the 4% rule is as high as I should go.

10 comments:

Hi Michael, you are spot on here. It is really surprising that people don't learn from the past. In the last century there might have been an excuse, but nowadays there is so much information around that nobody can reasonably say "the only way for the market is up".

Even the 4% rule is doubtful. From what I read, the best approach seems to be to tailor withdrawals to performance to leave as much of the principal "in the pot" as possible. In some years you can splurge your 20% on Aruba, in some years you better vacation in the pet food aisle at Costco.

Of course, that's the theory. Varying withdrawal rates is easier said than done.

@Holger: If you're going to subtract out inflation, you'd better add back in dividends. But I take your point that stock markets can have long periods of minimal returns. I agree that it can become necessary to adjust spending if markets perform poorly. This can be minimized by digging into fixed-income investments for a while, but a long enough period of bad stock returns will eventually force you to cut spending.

And I absolutely LOATHE how many corporate pension plans use market gains as an excuse to give "contribution holidays" and to raid money from the pension plans. Then when the markets tumble, sometimes drastically, the funds are seriously underfunded and they start talking pension payment cuts, rollbacks of other pension-funded benefits etc. They need to keep those wild gains in the account and keep contributions the same so they are ready to weather the next downturn.

@Bet Crooks: I agree there are problems here. This is one of the problems that target-benefit pension plans seek to fix. With such a plan there is not supposed to be any raiding. However, they have other issues.

Everyone knows the equation E=mc^2 which Einstein made famous, but nobody knows how it works aside from the few who take deep interest.

Similarly in investing, there is a simple truism: Price is what you pay, value is what you get. Intuitively, everyone understands this but most have difficulty determining "value".

1. If P << V, then it's a fantastic time to buy. (<< means much less than).2. If P = V, then the company must be earning more than your expected rate of return over the holding period for an investor to be happy.3. However, if P >> V, then it's time to sell and hold cash or seek other alternative investments where the two previous statements are true.

Today is one of those days where most individual companies are sitting at case 3. The availability of easy credit (zero interest rate policy) is evident in rising and levered merger/acquisition activity. The "reaching for yield" is evident in the full spectrum of credit markets (govt, corporate, special investment vehicles, etc), including low quality and sub-prime. Buffett's only macro measure (total stock market size vs GDP) has flipped well above 1:1. The odds are no longer in the rational investor's favour, so cash out some portion (i.e., those securities where P >> V within the portfolio) and sit on the sidelines. Any poker player that risks their entire capital when the odds are against them, faces the inevitable loss of capital on the current hand or a future hand. Investing is slightly more forgiving than poker unless your securities go to zero.

If you're playing poker (or investing), and you don't know the value of V, you're the "easy mark" in the game. However, if you do know the value of V, there are times to take advantage of the "easy marks".

Establishing V requires educating yourself and getting comfortable with the math. As an easy check, what are the great investors doing? Are they buying, selling, holding cash?

If you're an indexer, you'll know that you get more units of the index when P << V. Yes, you can overpay for an index when P >> V, but that's mindless. Scale back or eliminate new purchases and wait for the odds to return to your favour. Sitting on cash inflows for a couple of years can do wonders for your portfolio when P << V again. History is never the same, but it rhymes.

@Anonymous: You are advocating a market-timing strategy. History has shown that the majority of investors who attempt this fail. This includes many professional investors. The average person would be much better off to ignore any guesses of where value sits relative to price and just invest savings when they have money to save. The average person who believes he or she can succeed at market timing would also be better off not trying.

@Glenn: Good advice. My sons are just starting out as investors. I hope to help them understand the rebalancing (going against the flow) will help. If they get this then, yes, crashes are a good thing.